Climate risk management

Climate risk encompasses the potential financial and operational impacts arising from climate change, including both physical risks (e.g., extreme weather events) and transition risks (e.g., policy changes, market shifts).

• Physical risk involves the direct impact of climate change on assets, infrastructure and operations, such as damage from extreme weather events, rising sea levels and long-term shifts in climate patterns. Physical risks are divided into two categories:
  • Acute risks relate to extreme, abnormal climate and weather events such as floods, heat stress, wildfires and hurricanes.
  • Chronic risks relate to long-term changes to the environment and weather patterns. They arise from progressive shifts, such as increasing temperatures, sea-level rises, water stress, biodiversity loss, land use change, resource scarcity or habitat destruction.
• Transition risks arise from the implementation of new policies and regulations aimed at achieving net-zero emissions and a more sustainable economy, which entails significant structural changes to the economy. These transition risks could be triggered by:
  • Changes in regulations and policies such as increased pricing of greenhouse gas (GHG) emissions due to carbon taxation, direct regulation, enhanced emissions reporting, etc.
  • Changes in technology such as renewable energy, carbon capture and storage, lower emissions technology, etc.
  • Changes in consumer preferences and investment strategies, including changes in demand for carbon-intensive transport, energy-efficient housing and appliances, reputational risks, etc.
  • Change in reputation caused by increased stakeholder concern regarding the impact of companies on the environment or the stigmatisation of certain sectors.

Banks are affected by climate risk through potential credit losses, market volatility, operational disruptions and increased regulatory scrutiny. These risks can impact their financial stability and long-term viability. The Bank of International Settlements (BIS) defines climate-related financial risks as “the potential risks that may arise from climate change or from efforts to mitigate climate change, their related impacts and their economic and financial consequences”.

• In the UK, the main supervisory statement for banks and insurers is the SS319 - Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change published by the Prudential Regulation Authority (PRA) in April 2019, which is expected to be updated in 2025.
• In Europe, both the European Central Bank (ECB) and the European Banking Authority (EBA) have established frameworks to manage climate-related risks for financial institutions. The ECB published its Guide on climate-related and environmental risks in November 2020 and the EBA published the consultation paper, Guidelines on the management of ESG risks, in January 2024 to explore how these risks can be incorporated into the prudential framework.
• In October 2023, the US Federal Reserve published the SR 23-9: Principles for Climate-Related Financial Risk Management for Large Financial Institutions. In parallel, some states also established their own frameworks. This the case of New York with the Guidance for New York State Regulated Banking and Mortgage Organizations Relating to Management of Material Financial and Operational Risks from Climate Change published in December 2023. California also published the Climate Corporate Data Accountability Act (S.B. 253) and the Climate-Related Financial Risk Act (S.B. 261) in October 2023.
• In Canada, the Office of the Superintendent of Financial Institutions (OSFI) has issued a Climate Risk Management guideline outlining expectations for governance, risk management and climate-related financial disclosures. It includes requirements for climate scenario analysis, stress testing and capital and liquidity adequacy.

Climate risk assessment involves analysing exposure to physical and transition risks, evaluating potential financial impacts and integrating climate risk into overall risk management strategies. The main steps are as follows:

• Risk Identification: Understand and identify the types of climate risks faced by the organization and assess its vulnerability to them.
• Risk Assessment: Institutions utilise scenario analysis to evaluate the potential financial impacts of various climate scenarios. This process helps firms understand how different climate-related risks could affect asset values, liabilities and overall financial stability. It is essential to define models that translate climate risks into financial risks by considering their potentiality, vulnerability and impacts.
• Integration into Financial Risk Management: Climate risks are incorporated into existing risk management processes, including capital allocation, loan approvals and portfolio monitoring. Consequently, climate risk can be seen as a risk in itself or as a driver for more traditional financial risks (credit, market, etc.).

Main climate scenarios include various projections of future climate conditions based on different levels of GHG emissions, such as the Representative Concentration Pathways (RCPs) and Shared Socioeconomic Pathways (SSPs). Climate scenarios are usually long-term scenarios based on extensive analysis and modelling of key factors such as demography, energy demand projections, emission pathways, carbon budgets and policy and technology assumptions. Regulators and independent companies are also developing their own scenarios:

• ECB CST 2022 (Macro-financial scenarios for the 2022 climate risk stress test)
• BoE CBES 2021 (Results of the 2021 Climate Biennial Exploratory Scenario)
• FED CSA 2023 (The Fed - Overview of the Pilot CSA Exercise)
• OSFI SCSE 2024 (Standardized Climate Scenario Exercise - Office of the Superintendent of Financial Institutions)
• Network for Greening the Financial System (NGFS) scenarios (NGFS Scenarios Portal)

The objective of climate stress testing is to assess the resilience of financial institutions when faced with climate-related risks by simulating various adverse climate scenarios and evaluating their potential impacts in the short medium and long term.

Climate-related reporting standards are frameworks and guidelines that help organizations disclose information about their climate-related risks, opportunities and impacts. The main reporting standards are the following:

• Task Force on Climate-related Financial Disclosures (TCFD): Established by the G20’s Financial Stability Board, the TCFD provides recommendations for companies to disclose information on governance, strategy, risk management and metrics and targets related to climate change.
• IFRS Sustainability Disclosure Standards: Developed by the International Sustainability Standards Board (ISSB), these include:
• IFRS S1: General Requirements for Disclosure of Sustainability-related Financial Information.
• IFRS S2: Climate-related Disclosures.
• The Global Reporting Initiative (GRI): Provides a comprehensive set of standards for sustainability reporting, including climate-related disclosures.
• The European Sustainability Reporting Standards (ESRS): A set of standards developed by the European Financial Reporting Advisory Group (EFRAG) to guide companies in disclosing their sustainability-related information.

In April 2024, the BoE published an article with useful insights for financial institutions on using scenario analysis to measure climate-related financial risks. The article focuses on climate as a financial risk from a system-wide risk perspective and with regards to the BoE’s own financial operations. While not a supervisory guidance, the article explores how central banks and financial institutions can use scenario analysis to quantify these risks. It is therefore advisable for regulated firms to understand the key messages of this article and assess where they can incorporate these in their own thinking around quantifying climate risks as a part of their stress testing and ongoing operations. Find out more. 

• Governance Arrangements: Firms must embed the consideration of financial risks from climate change into their governance frameworks. This includes board-level oversight and clear allocation of responsibilities.
• Risk Management: Banks are expected to incorporate climate-related financial risks into their existing risk management practices. This involves identifying, assessing and managing these risks as part of their overall risk management framework.
• Scenario Analysis and Stress Testing: Firms should use scenario analysis to understand the potential impact of climate-related risks on their business. This helps in strategic planning and risk assessment.
• Disclosure: Banks are required to develop and implement an approach to disclose their exposure to climate-related financial risks. This includes transparency in how banks manage these risks and the impact on their financial position.